Although green bonds are extremely popular investment products, their tighter spread constrained supply present challenges to fixed income portfolios, according to Daintree Capital.
Daintree Capital is a globally unconstrained fixed income manager that integrates ESG as part of its investment process and invests in a range of bonds that have strong ESG characteristics, according to Brad Dunn, Senior Credit Analyst.
"We have an extensive checklist we undertake when we evaluate a company or issuance, and that's the first temperature check - to see if they meet the key ESG principles that we want to implement in the portfolio," Dunn said. "We look at the industries that they're involved in, where they earn their revenue, all the way through to more specific factors like percentage of revenue in industry categories."
Daintree screens out coal and energy extraction companies on environmental grounds, among other exclusions such as tobacco, controversial weapons, and, for New Zealand-based clients, whale meat and cannabis.
Daintree's fossil fuel exclusions are based on analysis of securities issuance against the backdrop of the transition to a low-carbon economy, Dunn noted.
"The way we structure the portfolio is relatively short-term," Dunn said. "Our longest dated paper is roughly seven years or so. Internally, we've had a lot of debate over this question in terms of assessing how much risk there is in some of those energy players that have 20 to 30 year investment projects against the backdrop of quite significant transition in the way we treat these assets over the next 10 years."
Daintree excludes holding bonds from thermal coal and energy companies, because that exclusion "most closely aligned with the values we want to espouse in our funds."
However, Dunn notes that the issue of fossil fuel investment isn't black and white, particularly in emerging markets, noting that while the IAEA report says that whilst money is pouring in to renewable energy projects and transition projects, approximately 40% of global energy will be based on renewable energy by 2050, which Dunn says means that by 2050 more electricity will still be generated from fossil fuels than by renewables, especially in emerging markets. Thus, it is not possible to simply exclude fossil fuel extraction in isolation and claim investments are making a difference.
"The developing world is where 65-70% of the global population sits," Dunn said. "In the cold hard light of day, if it's going to be a choice between them meeting the Paris Targets and keeping the lights on for residents, they will lean toward the prosperity element and continuation of growth, even if that means their decarbonisation transition is much slower than the developed world would like."
Green bonds and other affiliated categories like sustainability bonds also present challenges for the fund manager.
"When it comes to ESG bonds in the market, there is continuing to be that supply/demand imbalance," Dunn said. "If there was a new green bond mandate issued tomorrow, and assuming the contractual set-up was strong and ready to go, there would be a huge amount of demand in the market, and if you weren't able to secure the bond in the primary offering, it would trade very irregularly in the secondary market, or not at all, and when it did come to market, there would be a significant spread differential."
That can present risks for an investor like Daintree, Dunn said.
"We're not going to invest if it means giving up 10-30 basis points in return/spread," he said. "That's what we're continuing to grapple with in Daintree. Yes, we want to own green bonds, but our problem is that every time we find one that fits the criteria, it's almost always more expensive than a bond with all the same characteristics but without the green certification."